Commentary & Analysis
Preparing to acquire: the basics of due diligence (Part 2)
In Part 1 of this primer on evaluating acquisition targets, Paul Reilly and Peter Schaefer of New Direction Partners reviewed the questions a prospective buyer should ask about the things that make the seller's company productive: its plant, its equipment, and the state of its relations with employees. Their discussion continues with advice for assessing the outcomes of that productivity: the quality of the financial results; the condition of the customer base; and the nature of the relationships that the seller has with its suppliers.
By Patrick Henry
Published: July 20, 2010
Reilly says that the buyer and the buyer's advisers will want to examine annual and interim reports, including forecasts and projections, for at least the last three years. The indicators to look for in financial reviews, he emphasizes, are trends - patterns in the numbers that disclose how sturdy or questionable the seller's fundamentals really are.
To start, there's a lot to be learned from accounts receivable, allowing for the fact that activity here will be different at every printing company. A question about receivables that applies everywhere, says Reilly, is the degree to which they are concentrated - in other words, whether abnormally high percentages of receivables are generated by certain customers.
Schaefer notes that receivables aging will vary from plant to plant and that extended collection periods - say, 90 days - aren't necessarily alarming as long as the money comes in and the cycle remains stable. On the other hand, it is urgent to find out whether the seller's receivables include long-unpaid invoices from "doubtful accounts" that may have to be written off. Schaefer recommends obtaining detailed aging reports on both accounts payable and receivable and concentrating on items that diverge from the average number of days in each category.
To be scrutinized in the income statement are value added and gross margin, particularly the latter. Schaefer says that a very low gross margin might mean that pricing is inadequate or that the company is inefficient - both serious problems from the buyer's point of view.
Revenue, earnings, capital expenditures, cash flow, and debt-to-equity ratios may also contain trends that will prove crucial to the buyer's understanding of the seller's financial condition. Changes in these trends, says Schaefer, impact the balance sheet and the overall valuation of the company.
The review of adjustments to earnings should aim to uncover expenses and income items that can be taken off the books once the deal is closed: for example, excess compensation to shareholders and managers (including the owner); board of directors fees; and non-recurring expenses such as a charge for the installation of a press.
A matter of deep strategic concern is understanding the seller's customer base and the shares of the seller's business that each customer holds. A trap to be wary of, says Reilly, is the concentration of too much business in the hands of a few "sweetheart customers" whose accounts have become "anomalies" representing an inordinate share of the seller's profits. "How will you manage that risk?" Reilly asks, noting that customer loyalties don't always survive the sale of one printing company to another.
Schaefer says that if a review of contracts reveals heavy concentrations in certain accounts, steps must be taken to assure that the buyer won't be "fired" by any of these customers after the deal is closed. Relationship-cementing visits to these customers prior to closing will be in order, but Reilly adds a caveat: the seller may not want news of the sale to be divulged before the sale is final. But when the interests of the seller and the buyer are at odds in this way, the buyer must prevail. "Talk to the sweethearts," Reilly advises.
Other sales trends to look for are account turnover and replacement, growth of market share, and growth in share of customer. Schaefer recommends examining three to four years worth of sales history to get an accurate take on the nature and condition of the seller's customer base.
Dealings with suppliers
A buyer can take a useful hint from the way an acquisition target is treated by its suppliers, says Schaefer. if suppliers are dealing with the seller strictly on a COD basis, then the seller's firm probably is a troubled company. Another sign of trouble is the excessive spreading out of payments to suppliers - a potentially costly situation that the buyer would have to remedy once the deal was closed.
Because printers spend more money on paper than on any other consumable item, the seller's arrangements with its paper suppliers play straight into the shaping of a deal with the buyer The difference between what each pays for paper is the key consideration, but in this case, says Schaefer, the news is probably good for the buyer no matter where the difference lies.
If the buyer is paying less than the seller, that's an obvious plus, since the buyer will continue to source paper on that basis after the two companies are consolidated. On the other hand, Schaefer says, "it's not the worst thing in the world to find out that you're paying more," since that gives the buyer an incentive to renegotiate its own paper contracts in ways that will bring what it pays into line with what the seller has been paying. Assuming that the buyer is a larger company with a correspondingly larger demand for paper, merchants should be willing to adjust prices in order to capture the increased volume.
This scenario is just one example of how problems can become opportunities in a well planned and executed acquisition, Reilly says. Schaefer adds that other kinds of problems - such as the one that clearly exists "when the company is in trouble, and the owner drives up in a Ferrari" - have a way of vanishing on their own once the sale is concluded and transition to new management is under way.
Scrupulous attention to detail in the fact-finding phase that precedes the deal, they emphasize, is the key to uncovering and eliminating any problem that could stand in the way of a mutually beneficial deal